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Can Preferred Stock Enhance Your Portfolio?
By: Anthony M. Novara, CFA
Senior Research Analyst
With persistently low yields and investors thirsting for yield, it’s not difficult to understand why preferred stock is having a moment. Morningstar estimates the asset class has experienced cumulative net flows of approximately $16.8 billion over the last two and a half years for open-end funds and ETFs combined (see Exhibit 1 below). Despite a single calendar year of outflows in 2013, the asset class has experienced net fund flows every other calendar year since 2001, particularly since the financial crisis.  
EXHIBIT 1
While no single reason fully explains the investor attention, Exhibit 2 provides one key: above average yields. The iShares U.S. Preferred Stock ETF (PFF) represents the largest fund in the asset class and attempts to track the performance of the S&P U.S. Preferred Stock Index. Since the fund’s inception in 2007, yields have averaged 6.7%, including a fair amount of consistency since the financial crisis. The average is more than double the Barclays Aggregate yield to worst of approximately 3% over the same period, resulting in yield-starved investors fleeing to the asset class.
EXHIBIT 2
Before racing to include preferred stock in your portfolio, it is critical to understand the structure of preferred stock issues. First, preferred stocks are technically equity investments despite paying a fixed dividend since they are subordinated to all debt issued by a corporate issuer. In the event of bankruptcy, a company’s assets would first go to debtholders, then to preferred stock holders and lastly common equity holders. However, even though common shareholders are paid after preferred stock holders, preferred stock holders don’t share in the growth of the company like common equity holders since the economic benefit received on preferred stock is contractually fixed at the time of issuance. Thus, preferred stockholders receive a bond-like benefit but bear more credit risk than typical debtholders and don’t receive nearly as much potential economic benefit as common stockholders.

Second, many preferred stock issues have call provisions, which can hinder an investor’s return and create a negative asymmetry of outcomes for the investor. Compared to a non-callable bond that increases in value as interest rates decline, a callable preferred stock can experience all of the downside of an interest rate increase, but a capped appreciation for a commensurate decline in rates. Since many preferred stock issues have terms of 30-50 years on average, receiving long duration volatility but capped upside isn’t optimal.

Finally, the market price of a preferred stock issue will be dependent on the issuing company’s credit rating and therefore will decline if the credit quality of the company declines. Lower-rated, higher yielding issues might be called away and replaced with lower-yielding issues if creditworthiness of the company improves, increasing reinvestment risk for investors. In addition, a company can suspend preferred stock payments in times of stress if desired. None of these are favorable scenarios for investors.

Digging into the opportunity set of what can be purchased for inclusion in a portfolio is also helpful. Exhibit 3 displays the sector exposure of the iShares portfolio.
EXHIBIT 3
By nearly any definition, an ETF with approximately 79% exposure to financials is hardly a diversified opportunity set. With roughly 40% of the portfolio allocated to a single industry in bank preferred stock, the fund exhibits meaningful sector-specific risk. Moreover, only 1.5% of the ETF is A-rated or better, compared to 86.2% for the Barclays Aggregate Index1. Overall, the constrained opportunity set is not diversified by sector, lower quality as measured by credit ratings and also presents certain structural challenges.

With all the risks highlighted above, have investors historically been paid better risk-adjusted returns for the risks stated above? Exhibit 4 below illustrates rolling 3-year Sharpe ratios, returns and standard deviations for preferred stock, investment grade U.S. bonds (as measured by the Barclays Aggregate Index) and U.S. equities (as measured by the S&P 500 Index) since inception of the S&P Preferred Stock Index. While Sharpe ratios are presently above those of both the S&P 500 and the Barclays Aggregate Indices, historically the S&P Preferred Stock Index has often lagged the Barclays Aggregate Index on a Sharpe ratio basis and has had fairly mixed results when compared to the S&P 500 Index. On a 3-year rolling return basis, preferred stock has returned more than bonds, but has lagged stocks since the volatility of the financial crisis subsided.

Lastly, the third chart details that rolling standard deviation was nearly 30% during the financial crisis, more than 10% greater than the volatility of U.S. stocks over the same period. In other words, the historical results highlight that preferred stock is not for the faint of heart and remarkably more volatile than bonds (5% over the same period). In fact, the Preferred Stock Index’s drawdown of -54.6% was materially worse than that of the Barclays Aggregate Index, which returned +7.0% during the financial crisis (drawdown period from 9/30/07 to 2/28/09)2. Preferred stock also performed worse than the S&P 500 Index, which suffered a drawdown of -50.2% over that period3. In times of market duress, bonds and alleged bond-like instruments should act like bonds and certainly not worse than stocks if the goal is to benefit the investor with portfolio volatility and risk reduction. 
EXHIBIT 4
Looking beyond just the attractive yields, empirical evidence has not made a strong case for inclusion of preferred stock within diversified portfolios. High conviction asset classes should add to return, provide diversification benefits or both. Over the long-term, preferred stock has done neither in our view when compared to a straightforward combination of investment grade bonds and large cap equites. We believe a diversified and thoughtful mix of fixed income, equities, real assets and alternatives remains the most prudent approach to achieve optimal risk-adjusted returns.

For assistance with evaluating preferred stock or any other asset class, please contact any of the professionals at DiMeo Schneider & Associates, L.L.C.
1. Source: Bloomberg, Barclays
2. Source: Morningstar
3. Source: Morningstar
This report is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable though not independently verified. Any forecasts represent median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance does not indicate future performance.  
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